Investing Caffeine

The Big Short: The Silent Ticking Bomb

July 19, 2010 at 1:19 am 3 comments

A bomb was ticking for many years before the collapse of Bear Stearns in March of 2008, but unfortunately for most financial market participants, there were very few investors aware of the looming catastrophe. In The Big Short: Inside the Doomsday Machine, author Michael Lewis manages to craft a detailed account of the financial crisis by weaving in the exceptional personal stories of a handful of courageous capitalists. These financial sleuths manage not only to discover the explosive and toxic assets buried on the balance sheets of Wall Street giants, but also to realize massive profits for their successful detective skills.

Lewis was not dabbling in virgin territory when he decided to release yet another book on the financial crisis of 2008-2009. Nonetheless, even after slogging through Andrew Ross Sorkin’s Too Big to Fail and Gregory Zuckerman’s The Greatest Trade Ever (see my reviews on Too Big to Fail  and The Greatest Trade Ever),  I still felt obligated to add Michael Lewis’s The Big Short to my bookshelf (OK…my e-reader device). After all, he was the creator of Liar’s Poker, The New New Thing, Moneyball, and The Blind Side, among other books in his distinguished collection.

Genesis of the Bomb Creations

Like bomb sniffing dogs, the main characters that Lewis describes in The Big Short (Michael Burry/Scion Capital; Steve Eisman/Oppenheimer and Co. & FrontPoint Partners; Gregg Lippman/Deutsche Bank (DB); and Jamie Mai & Charlie Ledley/Cornwall Capital) demonstrate an uncanny ability to smell the inevitable destruction, and more importantly have the conviction to put their professional careers and financial wellbeing at risk by making a gutsy contrarian call on the demise of the subprime mortgage market.

How much dough did the characters in the book make? Jamie Mai and Charlie Ledley (Cornwall Capital) exemplify the payoff for those brave, and shrewd enough to short the housing market (luck never hurts either). Lewis highlights the Cornwall crew here:

“Cornwall Capital, started four and a half years earlier with $110,000, had just netted from a million-dollar bet, more than $80 million.”

Lewis goes on to describe the volatile period as “if bombs of differing sizes had been placed in virtually every major Western financial institution.” The size of U.S. subprime bombs (losses) exploding was estimated at around $1 trillion by the IMF (International Monetary Fund).  When it comes to some of the large publicly traded financial institutions, these money bombs manifested themselves in the form of about $50 billion in mortgage-related losses at Merrill Lynch (BAC), $60 billion at Citigroup (C), $9 billion at Morgan Stanley (MS), along with many others.

The subprime market, in and of itself, is actually not that large in the whole scheme of things. Definitions vary, but some described the market at around 7-8 million subprime mortgages outstanding during the peak of the market, which is a small fraction of the overall U.S. mortgage industry. The relatively small subprime market became a gargantuan problem when millions of lucrative subprime side-bets were created through investment banks and unregulated financial behemoths like AIG. The spirits of greed added fuel to the fire as the construction of credit default swap market and synthetic mortgage-backed CDOs (Collateralized Debt Obligations) were unleashed.

Triggering the Bomb

Multiple constituents, including the rating agencies (S&P [MHP], Moodys [MCO], Fitch) and banks, used faulty assumptions regarding the housing market. Since the subprime market was a somewhat new invention the mathematical models did not know how to properly incorporate declining (and/or moderating) national home prices, since national price declines were not consistent with historical housing data. These models were premised on the notion of Florida subprime price movements not being correlated (moving in opposite directions) with California subprime price movements. This thought process allowed S&P to provide roughly 80% of CDO issues with the top AAA-rating, despite a large percentage of these issues eventually going belly-up.

Lewis punctuated the faulty correlation reasoning underlying these subprime assumptions that dictated the banks’ reckless actions:

“The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces. In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.”

Steve Eisman adds his perspective about subprime modeling:

“Just throw the model in the garbage can. The models are all backward looking.”

Ignorance, greed, and other assumptions, such as the credibility of VAR (Value-at-Risk) metrics, accelerated the slope of the financial crisis decline.

Eisman had some choice words about many banking executives’ lack of knowledge, including his gem about Ken Lewis (former CEO of Bank of America):

“I had an epiphany. I said to myself, ‘Oh my God he’s dumb!’ A lightbulb went off. The guy running one of the biggest banks in the world is dumb!”

Or Eisman’s short fuse regarding the rating agency’s refusal to demand critical information from the investment banks due to fear of market share loss:

“Who’s in charge here? You’re the grown up. You’re the cop! Tell them to f**king give it to you!!!…S&P was worried if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings.”

A blatant conflict of interest exists between the issuer and rating agency, which needs to be rectified if credibility will ever return to the rating system. At a minimum, all fixed income investors should wake up and smell the coffee by doing more of their own homework, and relying less on the rubber stamp rating of others. The credit default swap market played a role in the subprime bubble bursting too. Without regulation, it becomes difficult to explain how AIG’s tiny FP (Financial Products) division could generate $300 million in profits annually, or at one point, 15% of AIG’s overall corporate profits.

My Take

The Big Short may simply be recycled financial crisis fodder regurgitated by countless observers, but regardless, there are plenty of redeeming moments in the book. Getting into the book took longer than I expected, given the pedigree and track record of Lewis. Nonetheless, after grinding slowly through about 2/3 of the book, I couldn’t put the thing down in the latter phases.

Lewis chose to take a micro view of the subprime mortgage market, with the personal stories, rather than a macro view. In the first 95% of the book, there is hardly a mention of Bear Stearns (JPM) Lehman Brothers, Citigroup, Goldman Sachs (GS), Fannie Mae (FNM), Freddie Mac (FRE), etc. Nevertheless, at the very end of the book, in the epilogue, Lewis attempts to put a hurried bow around the causes of and solutions to the financial crisis.

There is plenty of room to spread the blame, but Lewis singles out John Gutfreund’s (former Salomon Brothers) decision to take Solly public as a key pivotal point in the moral decline of the banking industry. For more than two decades since the publishing of Liar’s Poker, Lewis’s view on the overall industry remains skeptical:

“The incentives on Wall Street were all wrong; they’re still all wrong.”

His doubts may still remain about the health in the banking industry, and regardless of his forecasting prowess, Michael Lewis will continue sniffing out bombs and writing compelling books on a diverse set of subjects.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AIG subsidiary debt, but at the time of publishing SCM had no direct positions in BAC, JPM, FRE, FNM, DB, MS, GS, C, MCO, MHP, Fitch, any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Profiles, Themes - Trends. Tags: book, CDO, CDS, Liar's Poker, Michael Burry, Michael Lewis, mortgage, review, Steve Eisman, subprime, The Big Short.